Saturday, September 08, 2012

This week Wayne Swan implored the nation to celebrate an unbroken 21 years of economic growth - “21 continuous premierships in the row” - more than every other leading nation combined.

But no-one was popping champagne. Fortescue Metals founder Andrew Forrest was losing personal wealth at the rate of $150 million per day. At the start of July the iron ore spot price was $US127 a tonne. By Friday it had slipped below $US87. Importantly all of that 30 per cent slide in the spot price of Australia's biggest single export happened after the turn of the new financial year - it happened after the period covered by the June quarter national accounts of which the Treasurer was so proud.

Rarely has an economic report card been so obsolete the moment it was released.

The near-vertical slide in the iron ore price has gouged 40 per cent from the Fortescue’s share price since the start of July, ripped a billion dollars from the worth of its chairman, put it on Fitch Ratings negative credit watch and forced it to shed 1000 staff and wind back expansion programs already underway. Macquarie Equities says if it stays that low BHP's earnings will fall by a third, Rio’s will halve. It might have to borrow to pay its dividend. Gina Rinehart was said to be the world’s richest woman back in May when the iron ore price was $US145. Unless it recovers from its present level south of $US90, next year she will cede to the title to someone else - most probably the US Wal-Mart heiress Christy Walton.

It’s easy to be beguiled by the drama of a collapse that might always be reversed. The Swiss investor Mark Faber (known as Dr Doom) identifies four mega bubbles in the last four decades, the biggest of which is the ten-fold increase in the price of iron ore. He is able to produce a frightening graph making this year’s collapse in the iron ore price look like the earlier collapses in the price of gold, the Nikkei and the Nasdaq.

The accepted wisdom had been that an extraordinary 18 million Chinese were pouring from the countryside into cities each year - the entire adult population of Australia. Housing them had required steel, which could only be made from iron ore. The wisdom is being questioned because China's growth is slowing, it has unsold homes and it is closing steel mills.

The prime minister’s advisor on Asia Ken Henry affects an air of unconcern... Asked this week whether the mining boom was over he reframed the question. “There are people who would call the boom that is presently underway boom number two, so maybe the question should be, is boom number two over,” he told a seminar at the Australian National University.

“I would suggest to you that if this really is the end of boom number two, we will see boom number three, and we will see boom number four and we will see boom number five and so on.”

“My view is the minerals development projects underway in Australia have a very long way to run. There will be periods of relative weakness, but I wouldn't be writing off the minerals development story just yet.”

But in the here and now the collapse in resource prices is a serious problem. Reserve Bank governor Glenn Stevens drew attention to it in the statement released Tuesday after the board meeting that decided to shift the Bank’s interest rate stance from neutral to an “easing bias”.

Iron ore has accounted for 22 per cent of our exports, coal another 16 per cent. Mining tax and royalties from iron ore and coal have been factored into budgets. Western Australia was this year expecting to raise 17 per cent of its revenue from iron ore royalties. The Commonwealth was planning to raise $3 billion per year from a new minerals resource rent tax applying only to iron ore and coal.

Bank of America-Merrill Lynch chief economist Saul Eslake says coal and iron ore matter because they have been two of the major drivers of the economy. “Households have been cautious about their spending, most parts of the economy have been shrinking,” he says.

What’s galling to someone concerned about economic management is that they are coming off the boil at exactly the time the government has switched from pumping money into the economy to taking money out.

In the two months before the end of the financial year it showered households with $2.85 billion carbon tax and schoolkids bonus payments, insulating Australians from the downturn in national income. Local councils received their government payments early.

Department store spending climbed 1.2 and 3.7 per cent in May and June, then dived 10.2 per cent in July - its biggest slide in seven years.

The new financial year has begun with the resources downturn worsening and the government turning the money tap off. Everything has to be cut back in order to achieve the promised 2012-13 surplus.

And it probably have to be cut back more in the budget review due in November. Asked Wednesday what he would do if the iron ore price didn’t recover Swan said it would make his budget task harder and that he would cut harder.

“We are absolutely committed to delivering a surplus in 2012-13,” he said. “The government has a proven track record of delivering savings and we remain able and willing to do it again.”

Former Reserve Bank Board member Warwick McKibbin says cutting harder when economic activity is turning down is almost a definition of economic stupidity.

“It’s going to actually mean a much bigger slowdown in the economy. Any unit fall in the terms of trade is going to have a much bigger impact because of the feedback from fiscal policy.”

“What puzzles me is that Swan understood this. He was a Keynesian in 2008-09. In fact he claims he saved all those jobs by doing what he did. Why wouldn't he be arguing the thing same now, when the terms of trade are falling again?”

McKibbin says Swan should have abandoned his rigid commitment to a 2012-13 surplus as soon as it became clear the global financial crisis hadn’t ended.

“He had a perfect opportunity after the European crisis emerged to scale back his promise on the surplus and say: circumstances have changed, this is how we are going to deal with them. Instead he has held on and held on to the point where he is so locked in to a surplus that his credibility will be damaged unless he can deliver one.”

The Treasurer’s determination to return the budget to surplus no matter what will be made more painful by his earlier decisions to fund permanent increases in spending from vulnerable and uncertain mining and carbon tax proceeds.

The centrepiece of the this year’s May budget - the “spreading the benefits of the boom” family payments will cost around $1 billion per year, each and every year in perpetuity. The boom might end but the payments will continue for ever. The permanent cost to government of the superannuation increases was “funded” the same way. Pensions and other benefits have also been increased permanently to compensate for a carbon tax whose revenue will be uncertain and looks like undershooting earlier estimates.

And then there’s the National Disability Insurance Scheme and the dental scheme and the Gonski schools reforms. If the government knows how it will fund these on an ongoing basis, it hasn’t yet told us.

Treasury Secretary Martin Parkinson last month told a business audience Australia would soon be unable to meet demands for new government spending from the taxes it had.

“As Australian incomes have continued to rise over past decades, so too has community demand for the government provision of what economists call 'superior goods', including aged care, health, disability, education and social welfare. These pressures will only be exacerbated in coming decades as the population ages,” he said.

“At the same time, the taxation base is weaker than we had imagined in the mid-2000s. With hindsight, it is apparent that part of revenue collections then reflected a temporary bubble in the economy. The takeout message is that the days of large surpluses being delivered by buoyant tax receipts are behind us.”

McKibbin, an internationally-recognised economic modeller, thinks a public recognition of the problem is one of the reasons the public is reluctant to spend.

“In our models this effect is quite big. In the United States I think it’s one of the reasons no-one is spending, particularly corporations even though they've got money on their balance sheets. They don't know what taxes are going to have to rise to fix the fiscal position. They know someone is going to have to pay, so they save a bit more.”

“You talk to a taxi driver in Australia, or go to a pub. You’ll find people asking who’s going to pay for all this stuff now the boom is over. It is weighing on consumption and it is weighing on investment.”

Eslake agrees Swan has placed himself in an awful budget position. But he says it could give him the steel to make important savings.

“You know the saying, never waste a crisis? Well there is all sorts of middle-class welfare the government should be cutting -- superannuation concessions, negative gearing, family trusts and so on. Quite often desirable reforms take place only when a government is prepared to use a crisis to seize the day.”

And he says unless the resources downturn is really severe, the Reserve Bank might be able to handle it without support from the budget.

“If Wayne Swan’s need for a surplus prompts the Reserve Bank to ease monetary policy by more than it otherwise would, then there is probably no harm done.”

“The serious harm would be if they insisted on keeping the the budget in surplus in the face of an earthquake like 2008.”

“Bear in mind one of Australia's strengths is that we are one of only a handful of countries with a triple-A rating, and given that these days the costs of not having a triple-A rating are higher than they used to be, that's not something to be lightly thrown aside. So it depends on the circumstance - if we've got a Lehmann's style shock, a hard landing in China, then my view would be that not only should we let the budget go into deficit but that we should do some stimulus as well, and if that costs us the triple-A rating so be it.”

“But in other circumstances that fall well short of that, which is where I think we are at the moment, if you can cobble together a mix of policy changes that includes cutting government spending that is clearly wasteful or misdirected in order to preserve a surplus while also having bigger cuts in interest rates than you otherwise might, and ideally if that also led to a bigger fall in the dollar than otherwise would have occurred, then that's probably a sensible compromise to make.”

The high dollar is bedevilling economic management.

Normally when resource prices climb the dollar climbs to spread some of the benefits (via lower import prices) and move labour and capital away from competing trade exposed industries (by making them less competitive).

When resource prices slide the opposite is supposed to happen. The lower dollar is supposed to spread the pain via higher import prices and make previously uncompetitive trade exposed industries competitive again.

That’s the theory. This time the Aussie has stayed resolutely high in defiance of convention. Since July 1 the iron ore price has slid from $US127 a tonne to less than $US87. The Aussie remains about where it was on July 1, at a touch about 102 US cents (although in the meantime it had climbed as high as 105 US cents). Not only is Australia being denied the government spending shock absorber, it is also being denied the exchange rate shock absorber.

It’s been happening because foreigners love our high interest rates and out triple-A credit rating. McKibbin is among those urging the Reserve Bank to buy foreign assets with Australian dollars in order to nudge the Aussie down, although there were signs emerging this week that it might not need to bother.

Foreign buying of Australian government bonds fell to its lowest point in three years in the June quarter. The proportion held by foreigners slipped from 79 to 77.5 per cent. Although the iron ore slide itself hasn’t hurt the dollar, if foreigners start to believe it will hurt the dollar they could desert it en masse, leaving little holding it up.

“What we are referring to here is the well-known cartoon character who, when he’s chasing the Road Runner, frequently runs off the edge of a cliff,” he wrote to clients.

“Initially at least, he doesn’t fall. His legs are still running as if he is on land and he remains suspended in mid air. But then he looks down, and realises that there is nothing supporting him, and it is only then that he succumbs to the forces of gravity and plunges towards the valley floor.”

On Thursday AMP Capital chief economist Shane Oliver spoke of an 80 US cent dollar. He said if needed it would fall to 60 US cents.